What Are Accruals?

Accruals are fundamental principles in accounting that help ensure financial statements accurately reflect a company’s financial position and performance over a given period. These accounting entries recognise revenue and expenses when they are incurred, regardless of when cash is exchanged.

Understanding accruals is essential for investors, managers, and other stakeholders to gauge a company’s true financial health and performance.

Understanding Accruals

Accrual accounting is based on the matching principle, which dictates that revenues and expenses should be recognised in the same period in which they are earned or incurred, regardless of when cash is exchanged. This concept is crucial in the accrual method of accounting, which is the preferred method according to the Generally Accepted Accounting Principles (GAAP).

Accruals are made via adjusting journal entries at the end of each accounting period. This ensures that the financial statements include these amounts. By recognising revenues and expenses when they are earned or incurred, accruals provide a more accurate picture of a company’s financial health.

Types of Accruals

• Accrued Revenues: These are revenues that have been earned but not yet received. For example, a company provides services to a client in December but doesn’t receive payment until January of the following year. Even though the cash hasn’t been received, the revenue is recognised in December when the service was provided.
• Accrued Expenses: These are expenses that have been incurred but not yet paid. For instance, a company receives services from a supplier in December but doesn’t pay the invoice until January. The expense is recognised in December when the services were received, regardless of when the payment is made.

The Importance of Accruals

The accrual accounting method of accounting provides a more accurate picture of a company’s financial performance than cash-basis accounting, which only records transactions when cash is exchanged.

Here’s why accruals are essential:

• Matched Revenue and Expenses: Accruals ensure that revenues and their related expenses are recognised in the same period, allowing for a more accurate depiction of profitability.
• Better Decision Making: Accrual accounting provides timely and relevant information for decision-making by reflecting economic events as they occur, rather than when cash changes hands.
• Compliance: Accrual accounting is generally required for publicly traded companies under accounting standards such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
• Investor Confidence: Accurate financial reporting, facilitated by accruals, enhances investor confidence by providing a clearer understanding of a company’s financial position and performance.

Accruals in Company Financial Statements

Accruals play an important role in both the income statement and the balance sheet of a company, impacting how revenues, expenses, assets, and liabilities are recognised and reported.

Here’s how accruals work on each financial statement:

Income Statement

When a company provides goods or services to customers but has not yet received payment, it records the revenue as an accrual on the income statement. This involves recognising the revenue when it is earned, not when cash is received. The journal entry debits the revenue account and credits a balance sheet account (typically accounts receivable) to reflect the amount owed by customers for goods or services provided.

Similarly, when a company incurs expenses during an accounting period but has not yet paid for them, it records the expenses as accruals on the income statement. This involves recognising the expenses when they are incurred, not when cash is paid. The journal entry debits the appropriate expense account and credits a balance sheet account (usually accounts payable) to reflect the amount owed to suppliers for goods or services received.

Accruals ensure that revenues and expenses are matched to the period in which they are earned or incurred, providing a more accurate representation of the company’s profitability for that period.

Balance Sheet

When a company provides goods or services to customers on credit, it records the revenue as an accrual in the accounts receivable account on the balance sheet. This represents the amount customers owe to the company for goods or services already provided. Accounts receivable are considered assets because they represent the company’s right to receive payment in the future.

Conversely, when a company receives goods or services from a supplier but has not yet paid for them, it records the expenses as an accrual in the accounts payable account on the balance sheet. This represents the amount the company owes to its suppliers for goods or services received but not yet paid for. Accounts payable are considered liabilities because they represent the company’s obligation to pay in the future.

Accrual Adjustments

At the end of an accounting period, companies often make accrual adjustments to ensure that revenue and expenses are properly recognised. This involves estimating the amount of revenue earned or expenses incurred but not yet recorded, based on reliable information available at the time.

The Significance of Accruals in Accounting

Accrual accounting differs from cash accounting in its approach to recognising revenue and expenses. While cash accounting only records transactions when cash is exchanged, the accrual method of accounting adheres to the matching principle, recognising revenues and expenses in the period in which they are earned or incurred, irrespective of cash movements.

Accruals ensure a more accurate portrayal of a company’s financial health, facilitating better decision-making, compliance with accounting standards, and bolstering investor confidence.